Alert: Asset-Mix Whips and Ol' Inflation Saws

"[...]
to combat the depression by a forced credit expansion is to attempt to
cure the evil by the very means which brought it about; because we are
suffering from a misdirection of production, we want to create further
misdirection -- a procedure which can only lead to a much more severe crisis
as soon as the credit expansion comes to an end."

Frederich Hayek

We have come to the end of another quarterly strategy cycle and yet again
we are required to make significant changes to our portfolio strategies. "Long-term
investing" has become an oxymoron.

Three topical issues are top of mind at this juncture. For one, we had expected
a "Stop/Go/Stop scenario to play out economically (what others call the 'W")
before settling into one of the 5 longer-term scenarios that we had been probability-weighting.
(Please see our quarterly HITCH Update for a more detailed overview.)
Certainly, financial markets fulfilled our expectations and more in this regard.
However, we're worried that the predicted "Go" in North America is not yet
visible. Or, did we miss it? Could the tripping of the
"bond trap" have played a role?

Furthermore, even in China's manufacturing hub, where we were sure that the "bungee
cord" effect of a reversing inventory cycle and the "rocket ship"
effect of stimulative government spending would be first observed, has still
not served up incontrovertible evidence of a broad recovery. Speculative rebuilding
of industrial commodity inventories and other factors have padded the statistics.
In the meantime, other economic indicators -- i.e. basic power consumption
-- have signaled contrary trends.

Recovery? G8 financial heads likely are congratulating themselves much too
early on a crisis well averted. Any thought of pulling life-support at this
late terminus will not be received well by financials markets.

With respect to our anticipated "Go" stage, are we being dealt a "Go to Jail,
Do not Pass Go" card? Given the scale of the global equity market rallies to
date, there's not much to be gained remaining overly exposed to "high beta."
As such, countertrend to consensus, we've recalibrated our portfolios this
quarter to again lower risk.

The second conundrum on our minds is the apparent gross misreading of inflationary
conditions. Even Paul Kasriel, a highly-regarded analyst and apparent adherent
to the Austrian School, we fear, has terribly misread the tea leaves. But let's
be clear before we digress. There currently exists enormous monetary inflation.
There is no doubt on this matter as inflation is essentially a monetary phenomenon.
With central bank balance sheets doubling and trebling over the past 12 months,
there is lots of monetary inflation seeking to work its alchemy. How it will
manifest itself is an entirely different question.

Here, we best be on guard for the very deserved reason that inflation is
a chameleon. It likes to fool most people all of the time ... even Austrian
School devotees. In terms of its popular public conception -- namely the prices
of the current output of GDP ... i.e. the CPI or the GDP deflator -- sometimes
you see it, sometimes you don't. This is a most unreliable indication of the
destructive distortions of inflation, in any case (it being a symptom, not
a cause). But what other channels could inflation be impacting now?

First, off, let's reaffirm some ol' time theory. In the classical view, in
addition to rising consumer prices, manifestations of inflation include:

1. Asset inflation ... the kind everyone likes, at least until it collapses
from an unsustainable bubble and related credit problems ... of existing
assets that are not current output of GDP.

2. Gross distortions in the input/output structure of an economy. This
is a technical concept involving malinvestment best explained with this example:
When U.S. retail store space doubled from 19 to 38 square feet per capita
between 1990 and 2005, this was definitely a distortion of the input/output
structure of the American economy. (By comparison, most European countries
have less than 10 square feet per capita.)

3. Chronic external deficits -- for example a current account deficit --
requiring reliance upon international borrowing to sustain its spending and/or
investment.

4. Shifts on the household's balance sheet that lead to a plunge in personal
savings rates.

5. Widening income and wealth skews in the general population. This last
indicator is not normally considered a text-book manifestation of inflation.
Under certain conditions, such as are being experienced today, we make the
case that it is. We will explain further.

There is yet one more manifestation that may be missed right now. Monetary
inflation has been expressly marshaled to tamper with risk spreads in the credit
markets. Most monetary inflation hasn't gone much anywhere else to this point,
certainly not in the US. The Fed itself has used its expanded balance sheet
(which is monetary inflation) to buy assets other than treasuries. Also, other
government programs have been funded to support "troubled assets."

Another factor perhaps ignored is that actual monetary destruction has occurred
in the banking system. In other words, assets have been written off as worthless
(impaired), thus crimping the banking system's balance sheet. That, technically,
can be seen as a monetary event. To the extent that monetary inflation is deployed
to fill in
"deep black financial holes" by virtue of relative price distortions in credit
markets or other means, that is indeed another manifestation of inflation.

All of the above, serves as a lead-up to this assertion: Narrowing yield/risk
spreads in credit markets in the aftermath of the GFC, are not necessarily
proof that there is actually a growing and natural preference for higher credit
risk. As Kasriel concludes: "If the current and increased supply of Treasury
debt coming to market were
'crowding out' private debt issuance, then the yields on privately-issued
debt would be holding steady or rising in tandem with the rise in the Treasury
bond yield." Whoa! With huge dollops of monetary inflation specifically directed
to messing with natural pricing of credit risk, this conclusion does not necessarily
follow.

In the meantime, the US bond market is doing its job of regulating capital
supply and "price" inflation fears (i.e. the opposite cousin to asset inflation).
Those of us who are rightly worried that "velocity inflations" (a unique distributive
variant of asset inflation) may erupt in certain
"hard" assets types, are also best reminded that a large, functioning and alert
bond market is the best protection against rampant price inflation. Mainly,
that is what the sharply rising bond yields are signaling. (Shades of Ed
Yardeni's concept of the "bond vigilantes.") This "inflation sentinel" is
something that Zimbabwe and the Weimar era did not have. At present, there
is way more supply of government bonds than there is appetite and inflationary
complacency (and this, despite no hint of any US dollar funding crisis!)

Given the slow traction of economic growth, the slumping bond markets are
best read as signaling another economic slowdown later this year. Protesters
to this interpretation will argue that the rise in long-term rates has nothing
to do with rising demand in the private economy .Therefore, how should it slow
what hasn't accelerated much? Well, that's the crowding-out effect. What we
are witnessing, alas, is the catch-22 to financial godhood for Geithner and
Bernanke. Only through the scares of a deeper economic slump or a phase-2 of
GFC, will investors be willing to pile back into longer-term government bonds.
And, maybe not then either.

Finally, commenting upon investment performance year-to-date, all we can
say is that it's been one of those years that throws a curve ball into the
theories of performance measurement consultants. Even managers that have successfully
pursued long-term allocation strategies will have some explaining to do. Why?
Active managers are bound to have recorded high performance volatility against
benchmark this year (unless they whimped out and hugged the benchmarks throughout
the steepest stock market decline in a century). Of course, the reason that
people hire asset managers in the first place is for "positive" volatility
against benchmark ... as much as safely possible. But here now comes to play
the catch-22 of the consultants. If you deliver too much "positive volatility," this
apparently is taken as evidence that you have subjected portfolios to too much
risk. In certain situations -- certainly this year -- such a contention is
nonsense. When the entire financial universe is polluted with mispriced risk,
who is to say?

Long-term oriented asset managers, of course, had no complicity in the sharp
and reversing financial market movements witnessed to date this year. These
have been of a scale that have turned long-term strategies into shortterm trades.
In other words, decisions that were theoretically based upon longer-term return
and risk expectations, were either validated or disproved in a matter of weeks.

The granddaddy of these moves has been the relative performance of stocks
versus longer-term bonds. Figure #1 illustrates the sharp and defined diversion
between these two asset classes. The rotation we have witnessed this year is
simply unprecedented ... either career-making or -breaking. In fact, the relative
volatility between these two asset classes today makes the 1987 experience
look like a shrinking violet. (See 360 View on the front page.)

Our conclusions? We would dearly like to join the effusive enthusiasm for
an imminent economic recovery ... a sustainable, self-replicating kind that
has been the usual type of the post-WW II era up until 2000. While we have
had to be in the reflation trade since last year, we think there is little
to be gained waiting for a economic recovery to appear when long-term yields
are soaring to extremely high real levels.

Theory and history argue that the full ramifications of the GFC have not
yet fully played out. There are still many repercussions that will leave their
legacy over the next few years. The current equity rallies presume a trouble
free future and a return to the economic growth rates of the past several decades.
This is virtually impossible for the Western parts of the world economy.

Wilfred Hahn is intimately familiar with the many facets and challenges of
the world of money, having worked in the global financial and investment industry
for over two decades.

Business and research travels have brought Wilfred to 40 countries around
the world, allowing him a unique opportunity to keep abreast of global developments
and to maintain an international network of contacts. He is a published author
and has written on global financial markets, ethics and stewardship issues.
When Euromoney Magazine asked fund managers around the world to name
their favorite domestic and international research analysts, Wilfred was chosen
one of them. Many foreign publications around the world have quoted Wilfred,
including the South China Morning Post, Wall Street Journal, New York Times,
Frankfurter Allgemeine, and the Financial Post. He has made numerous
appearances on various television and radio broadcasts.

Prior to founding Hahn Investment Stewards, Wilfred was head of the Global
Investment Group of the Royal Bank of Canada. In this position, he built the
global discretionary business of this institution, comprising the activities
of staff in nine countries and assets of clients totaling in excess of $10
billion. The group's many clients around the world included pension funds,
corporations, mutual fund unit-holders and private individuals.

Prior to the Royal Bank he co-founded Hahn Capital Partners Inc. - a global
investment counseling firm that was sold to the Royal Bank of Canada. Earlier
in his career Wilfred was Senior Vice President, Director of Research of Prudential
Bache Securities. There he gained extensive global experience, establishing
a high ranking as a financial market strategist. Earlier, Wilfred was a partner
in the investment banking firm of Gordon Capital Inc.